There’s a Reason Why It’s Called a “Stop Payment” Notice Not a “Let Me Pay Myself First” Notice

In a decision published January 31, 2014 (Brewer Corp. v. Point Center Financial, Inc.), the California Court of Appeal (Fourth District) affirmed a trial court’s judgment holding a lender liable for contractors’ stop notice claims, rejecting the lender’s contention that its disbursements to itself (for interest, loan fees, and other expenses) took priority over the stop notice claims.

Background

The lender (Point Center Financial, Inc.) arranged a $13.6 million loan for the completion of construction on a condominium project in San Diego.  Third party investors funded most of the loan.  The lender entered into private loan servicing agreements with the investors.  Under those agreements, the lender paid investors interest on their fractional loan interest, and charged a servicing fee of 1.5 percent.  The lender also pre-paid itself interest and fees totaling over $1.5 million.

The lender raised and disbursed a total of just over $12 million, but never funded the remaining balance of the loan amount.  Various contractors provided labor, services, equipment, and materials to the project.  One contractor served a bonded stop notice in June 2007, but the lender failed to withhold funds.  By the time additional contractors filed stop notices in early 2008, the lender had already fully disbursed all of the loan funds it had held.

The contractors sued, and in its main holding the trial court ruled in their favor, stating that the contractors’ stop notice claims took precedence over the lender’s contractual right to pay itself interest, loan fees, and other preallocated expenses.  The court entered judgment for the contractors for over $1.5 million.

The lender appealed.

A Construction Lender Must Make Available to Stop Notice Claimants Amounts the Lender has Already Disbursed to Itself

The court of appeal affirmed the trial court’s ruling, confirming that a “stop notice claimant obtains priority over any ‘assignment’ of the construction loan funds, whether the assignment is made before or after a stop notice is served.”  Following an earlier published decision on point (Familian Corp v. Imperial Bank (1989) 213 Cal.App.3d 681), the court held that the lender’s preallocation and disbursement of funds to pay interest, fees, and other non-construction costs – pursuant to its private loan servicing agreements with its investors – constituted an “assignment” that was subordinate to the perfected claims of the contractors.  The court cited the purpose of the stop notice procedure: “The Legislature created the stop notice law to give laborers and materialmen priority over lenders to payment from the construction loan fund.”

The court rejected the lender’s argument that it had “earned” its disbursements because they were really reimbursements for out of pocket costs associated with locating investors, raising funds, and associated costs.  Monies in a construction loan fund, the court held, are intended to pay construction costs, not ordinary expenses.  The court also rejected the lender’s arguments that it suffered an overall loss on the loan, and that most of the monies that it disbursed to itself were later disbursed to the third party investors.  The court held that the lender’s “gain or loss,” and whether it retained its disbursements or passed them to third parties, were not relevant.

The Importance of Properly Serving a Preliminary Notice and a Notice of Commencement of a Stop Notice Action

Aside from its main holding, the court of appeal also addressed two noteworthy procedural issues regarding the service of stop notice-related documents.

First, the court addressed one contractor’s failure to serve a preliminary 20-day notice on the lender, which is normally a prerequisite to maintaining a claim.  The court remanded the case back to the trial court for an evidentiary hearing as to whether the contractor had a “factual excuse” for not serving the lender with the preliminary notice based on the contractor’s contention that it had started work on the project before the lender recorded its construction loan deed.

Second, the court addressed another contractor’s admitted failure to serve the lender with a notice of the commencement of its stop notice action within five days after filing its complaint.  The lender contended that this failure required the dismissal of the contractor’s lawsuit.  The court disagreed, holding the lender suffered “no prejudice” since the lender had already received the contractor’s stop notice (at which time the lender had no undisbursed construction funds left in its control).

Lessons

• The fact that a construction loan fund sits empty and fully disbursed does not mean that a contractor is left empty-handed on a stop notice claim.  A stop notice can give the contractor priority over any “assignment” of the construction loan funds, and an “assignment” can include a lender’s preallocation and disbursement of funds to pay itself (and third party investors) interest, fees, and other non-construction expenses.

• Properly serving a preliminary notice and a notice of commencement of a stop notice action are critical procedural steps.  While shortcomings in service might be “excused” based on certain facts or pardoned based on an absence of prejudice, the best course is to serve properly and eliminate all doubts regarding procedural compliance.